A fundamental service offered by a financial institution is to act as a repository for a customer's investments and to account for the distribution and growth of those investments. The financial services offered by a prime broker to a hedge fund are an example of such services. As is often the case in this relationship, a prime broker provides and services a single or main account in which a hedge fund may maintain all of its cash and securities. By providing these services to a hedge fund money manager, the prime broker can allow the money manager to focus on the investments in the hedge fund rather than attending to accounting or banking details necessary to operate the fund. A prime broker may also offer other services to the hedge fund. These can include cash management, reporting, and money lending.
In theory, a money manager of a hedge fund will be able to trade with several brokerage houses while maintaining a single account at the prime broker. By relying on these banking services from a single prime broker, a money manager may be freed to work with several brokerage houses rather than having to rely on a single brokerage house to provide all of these services. An advantage of maintaining relationships with several brokerage houses is that the money manager may learn about business opportunities, including IPOs, from several sources.
The origins of a prime brokerage account are commonly thought to date back to the late 1970's. Over the years the products offered by these prime brokers have changed, from a largely equity based product to more diverse services. These may include fixed income and derivative offerings, and foreign exchange and futures products. In each instance, these prime brokers have been separate entities apart from the brokerage houses and apart from the hedge funds that the money managers work for.
Today, prime brokers offer services in a competitive industry with high demands from the hedge fund industry. These prime brokers may generate revenues from commissions and fees on transactions, from spreads on loans, and by sophisticated financing products such as swaps and CFDs (Contracts for Difference). In some situations the prime broker may be exposed to loss if collateral held to secure loans falls below the value of the loan and the loan defaults. There are other risks as well.
Although commercial banks may make available to their clients a variety of discrete services that overlap with some of the specific services provided to hedge funds by prime brokers, as a general matter they have not sought to provide such clients with an integrated set of services replicating all of the services normally provided to a hedge fund by a prime broker.